Credit risk and market conditions are inherently linked. This link manifests itself in multiple channels. It has been documented that default probabilities and recovery rates vary through business cycles (see, e.g., Altman (1983), Acharya, Bharath, and Srinivasan (2007), Du-e, Saitaand Wang (2007), and Pesaran, Schuermann, Treutlerand Weiner (2006))). Market conditions can alsoafiectthe impact off firm characteristics on default probability and credit spread, because economically sensitiveflrms should beneflt more in economic expansions and sufiermorein economic recessions. Traditional structural models based on the seminal Merton (1974) model, however, have generally not properly accounted for these inherent connections and have consequently failed to match the levels of the observed credits spreads ("the credit spread puzzle").
Recently, there area number of the oretical papers that directly examine the impact of market risk on credit spreads. Tang and Yan (2006) investigate the dynamics off firm-level credit spreads by highlighting the role of a firm cash flow beta that measures its exposure to the macro-economic risk. They show that the incorporation of the macroeconomic influuenceon firms cash floow process helps improve the fit of default probabilities and credit spreadssigniflcantly, even in the absence of a complicated preference structure and a jump component in the firm's cash flow process.
Other papers introduce a habit-formation ora recursive preference structure in order to illustrate the connection between the equity risk premium puzzle and the credit spread puzzle (Bhamra, Kuehnand Strebulaev (2007) and Chen, Collin-Dufresneand Goldstein (2007)), or reconcile the observed high credit spreads with low corporate leverage ratios (Chen (2007)). Moreover, Chen (2007) and David (2007) consider the impact of inflationandallow fora regime-switching in the growth rate of aggregate consumption or production to capture the uncertainty in business cycles. With these added features, these models can be calibrated to provide reasonable predictions of credit spreads consistent with empirical data.
